Regular readers will be familiar with the ‘debtflation debate' - see The Global Monetary Analyst: Debtflation, October 21, 2009, The Global Monetary Analyst: The Return of Debtflation? February 10, 2010, and The Global Monetary Analyst: Debating Debtflation, March 3, 2010, for our arguments and US Economics: We Can't Inflate Our Way Out, Richard Berner, February 19, 2010, and The Global Monetary Analyst: Default or Inflate or..., Gerard Minack, February 23, 2010, for pushback from our colleagues. Irrespective of where one stands on this debate, we think that a look at the laundry list of some of the most important factors regarding the temptation to inflate is instructive.
The obvious metric is of course the total amount of public debt - the higher, the bigger the incentive to inflate. This is borne out by ample historical and statistical evidence on the link between sovereign fiscal positions and inflation. But there are further factors which determine the incentive to inflate: the average duration/maturity of the debt; the currency denomination of the debt; the share of domestic versus foreign ownership; and the proportion of inflation-proof debt in the total amount of outstanding debt. This is how each of these factors affects the incentive to inflate:
• Public debt overhang: The higher the outstanding amount of government debt, the greater the burden of servicing it. Hence, the temptation to inflate increases with the debt.
• Maturity of the debt: The longer the maturity of the debt, the easier it is for a government to reduce the real costs of debt service. To take an extreme example, if the maturity of the debt is zero - i.e., the entire stock of debt rolls every period - then it would be impossible to reduce the debt burden if yields respond immediately and fully to higher inflation. Hence, the longer the maturity of the debt, the greater the temptation to inflate.
• Currency denomination of the debt: Own currency debt can be inflated away easily. Foreign currency-denominated debt on the other hand cannot be inflated away. Worse, the currency depreciation that will be the likely consequence of higher inflation would make it more difficult to repay foreign currency debt: government tax revenues are in domestic currency, and the domestic currency would be worth less in foreign currency. So, the temptation to inflate increases with the share of debt denominated in domestic currency.
• Foreign versus domestic ownership of debt: The ownership of debt determines who will be affected by higher inflation. The higher the foreign ownership, the less will the fall in the real value of government debt affect domestic residents. This matters not least because only domestic residents vote in elections. Note that unlike domestic owners, foreign owners may not necessarily be interested in the real value of government debt since they consume goods in their own country. But they will nonetheless be affected by the inflation-induced depreciation. So, the temptation to inflate increases with the share of foreign ownership of the debt.
• Proportion of debt indexed to inflation: By construction, indexed debt cannot be inflated away. Hence, the higher the proportion of debt that is indexed to inflation, the lower the temptation to inflate.
To these purely fiscal arguments we add another dimension, private sector indebtedness:
• Private sector debt overhang: An overlevered private sector may generate macroeconomic fragility and pose a threat to public balance sheets. Hence, high private debt also increases the incentive to inflate.
We have compiled data on these factors at the end of the article for the US, UK, Japan and some euro area sovereigns. We also look at past inflation performance, measured by average and peak inflation rates for the period 1960-2008. These are - admittedly rough - proxies for the attitude towards inflation in the respective societies. How do these countries compare on our metrics?
The public debt situation is familiar and requires no elaboration that the euro area as a whole has a similar level of gross debt as the US and the UK - though the average masks the familiar core-periphery divide in sovereign balance sheets.
On the private debt front, the standouts for household indebtedness are the US and the UK (as well as euro-zone members Spain and Portugal). Japan has highly levered corporates, both financial and non-financial, while the UK has a highly indebted financial sector. Euro area corporates are more indebted than US corporates. Overall, high levels of debt, to the extent that they indicate macroeconomic fragility and a threat to public sector balance sheets, are a problem everywhere in the G4 economies. Taking into account both public and private sector balance sheets, the temptation to inflate is substantial in all these economies.
There is also little to separate the countries in our sample with respect to currency denomination. All have debt that is almost in its entirety denominated in their own currency. In terms of the average maturity of the debt, the UK is a clear outlier at 13.5 years - suggesting a significant temptation to inflate.
In the US, on the other hand, the outstanding maturity is the lowest in our sample. However, average maturity of Treasury debt is set to rise quickly to post-war average levels on our US team's forecasts - and possibly beyond, if the historically strong positive correlation between the debt ratio and average maturity is anything to go by.
With regards to foreign ownership of debt, the euro area sovereigns have a very high degree of foreign ownership. However, because of cross-euro area holdings, what matters in this context is the share of debt held outside the euro area rather than outside an individual euro area country. Even though we have no hard data to back this up, anecdotal evidence suggests that most of the government debt is held within the euro area - due to the high degree of financial market integration. This would moderate any temptation to inflate, since euro area sovereign debt is mostly held within the euro area. Leaving the euro area aside, the US has the highest proportion of foreign-owned debt (nearly 50%) - a reflection of the dollar's global reserve currency status - and Japan the lowest (around 7%), with the UK somewhere in the middle (28%). Bearing in mind the caveat about the euro area, the US certainly stands out along this dimension of inflation temptation.
Finally, the proportion of debt indexed to inflation is low in Japan, the euro-zone and the US but very high in the UK, where inflation-proof debt makes up 20% of total debt. This provides an important counterweight to the debtflation temptation arising from high debt and ultra-long debt maturities.
So, which economies stand out with respect to overall inflation temptation? We think the temptation is higher in the US and the UK than in the euro-zone - if the ECB conducts monetary policy for the average - and lowest in Japan. Here's why:
From our bird's eye view of the numbers, Japan probably has the worst balance sheet, followed by the UK and the US - assuming that what matters for the euro-zone is the average and not its weakest link(s). On the other hand, Japan's public debt is mostly held domestically and its debt maturity is relatively short. These factors moderate the temptation to inflate arising from high public and private indebtedness. Indeed, the fact that the Japanese economy as a whole is a net foreign creditor to the tune of 50% of its GDP is another indication that much of the leverage of individual sectors is debt held by other domestic sectors - public debt for example being held by households and financial institutions. This means that the temptation to inflate is ultimately very low, despite high leverage.
The euro-zone seems to occupy the middle ground in our inverse beauty contest on just about all metrics. Risks to (price) stability for the euro area arise to the extent that the average masks some vulnerable economies. For example, there have been calls recently for the ECB to generate higher inflation because this would help the struggling periphery: expansionary policy would stimulate demand, and regaining competitiveness for the peripherals would require fewer outright nominal wage cuts. The incentive to inflate for the ECB would, in our view, arise to the extent that it perceives higher inflation to be conducive to rebalancing the euro-zone; this would make a hypothetical break-up less likely, thereby preserving the status - or even the very existence - of the Frankfurt institution. We attach a very low probability to this scenario, however, not least because the institutional set-up of the ECB ensures that no particular (group of) countries' interests prevail.
How about the US and the UK? We've already noted that both public and private sectors are highly levered. In the US, foreign ownership of public debt is very high, and the share of inflation-proof debt is relatively low (though higher than any of the euro area countries in our sample) - factors favourable to inflation. Debt maturity is short by international standards, but rising quickly towards the US historical average - and possibly beyond, if the historical correlation between debt and maturity is anything to go by. In the UK, debt maturity is very long but the share of inflation-proof debt is elevated. However, the UK has had a much worse inflation performance historically: average and peak inflation rates have been substantially higher than in the US. Overall, while the temptation to inflate in the two countries is higher than in the euro-zone or Japan, it is difficult to distinguish between the two.
Of course, our list of factors is far from exhaustive. In particular, it does not capture the ‘soft' aspects of the problem. Reputation is clearly a factor in this context. A reputation for stability - in the central bank context this means achieving low inflation on a sustained basis - takes a long time to build but very little to lose. This speaks against inflation as a course of action for central banks.
How about timing - when are we likely to see inflation if the risks were to materialise? Clearly, variations in the pace of cyclical recovery imply a different near-term inflation outlook for different economies. Our US team expects the inflation outlook to start turning towards the middle of the year; in the euro area, inflation will likely remain subdued for a while longer, given the tepid recovery; and Japan will likely remain mired in deflation for some time. Hence, inflation is unlikely to become a near-term worry. Returning to our debtflation framework, incentives also suggest that it is too early for the authorities to generate inflation. Some clients have pushed back - and we agree - that, for practical purposes, the duration of debt is shorter than meets the eye because large current deficits mean large immediate financing needs. From a strict ‘rational debtflation' point of view, the optimal timing for inflation would be when the bulk of borrowing is behind us (and maturities are longer in the US). On our forecasts, deficits will be slow to come down (see Global Forecast Snapshots: What Fiscal Tightening? March 10, 2010). Hence, inflation may still be a good 2-3 years off. But if we are right about output gaps being smaller than commonly appreciated, or if strong EM economies put pressure on commodity prices, then inflation may appear sooner than many think.
Investment conclusion: Beyond the next two years, we should be worried about high inflation outcomes. While pension fund demand means that UK inflation protection is already demandingly priced relative to the MPC's inflation target, we think that the downside risk of being long protection is limited due to the persistence of this demand.
Short-Term Inflation Outlook: A Bumpy Ride Over the Next Two Years
Our central case is still that CPI inflation declines significantly over the rest of this year, spends all of 2011 below target, gradually increasing to hit the target in 1Q12. Our economic models, incorporating our below-consensus GDP forecasts, suggest downside risks to our inflation forecasts. With this in mind, we lower our inflation forecasts slightly and push back the date we expect monetary tightening to start into 2011. However, inflation has been surprising on the upside and further inflation shocks seem likely (mostly upside ones). This risks the continued missing of the inflation target and that inflation expectations might become ‘unhinged'. Expect a bumpy road ahead.
Recent upside inflation surprises: Despite a substantial margin of spare capacity, CPI inflation has not fallen to the extent that we expected at the end of 2008. Although central Bank of England forecasts (as of November 2008) were actually too high, nevertheless at successive inflation forecasting rounds, 2009 inflation ultimately came in higher than the Bank of England expected too.
Lots of shocks: drivers of higher-than-expected inflation: Over 2009, inflation outcomes have been broadly stronger than expected. Monthly inflation has been consistent with meeting the Bank of England's 2% target. Over the last two years, monthly inflation has only been below this line six times (out of 24 outturns). Drivers of higher-than-expected inflation included:
• Lagged effects of currency weakness: In 1H09, inflation rose sharply in several components of inflation that have a high import content (particularly clothing/footwear, recreation and culture (includes DVDs and flat-screen TVs for example), communication (includes mobile phone handsets) and furniture/furnishings).
• Higher oil prices and VAT: In 2H09, currency effects continued to boost inflation. Higher oil prices led to a big increase in transport inflation and changes in VAT boosted inflation significantly at the turn of the year.
Beyond the Next Two Years: The Only Way Is Up?
So long as the Bank of England is required to maintain a 2% inflation target, we don't think that investors should be overly concerned about prolonged periods of significantly above 2% CPI inflation. We think that monetary policy works so that, as long as the government of the day sticks with the current monetary policy framework, 2% CPI inflation is a reasonable longer-term assumption.
However, we see significant potential for two alternative outcomes here:
First, the government of the day decides to raise the inflation target. We don't think that this outcome, by choice, is likely.
Second, maintaining the inflation target becomes untenable thanks to any of four pressures. These are:
1) Inflation expectations become unhinged because of missing the inflation target and forecasting errors.
2) Commodity prices cause significant longer-term inflation pressure.
3) The government finds it near impossible to eliminate the structural deficit (and hence inflation expectations rise significantly), potentially because;
4) Demographic trends mean that it is hard for the real economy to grow fast and the tax burden on workers needed to pay for age-related expenditure is politically (and economically) unpalatable. Taxation pressures on worker incomes lead to significant wage pressures.
These four sources of inflationary pressure could mean that, with the current monetary policy regime intact, the costs to the real economy of trying to return overall inflation to 2% (likely significantly higher real interest rates and a very weak domestic economy) would ultimately become politically untenable and force a change in the monetary policy framework.
We raise our own average forecast for 2011-15 from 2.0% to 2.4% on the back of some of the upside risks analysed in this report (consistent with RPI inflation at about 3.0% before building in any changes in interest rate profile). This reflects some of these inflation pressures coming through, with the Bank of England ultimately steering inflation back to target. However, the longer-term pressures (particularly demography) are likely to play out more strongly beyond this horizon, and it is the period beyond 2014/15 where we are most concerned about a scenario where the inflation target becomes untenable.
For further details, see The Only Way Is Up? The Potential for Higher Inflation after a Temporary Reprieve, March 31, 2010.
Introduction
The lower bound on nominal interest rates has been a crucial problem for Japan. As prices decline, the real interest rate has risen, choking off investment, worsening growth and worsening deflation even more. For Japan to return to stable, self-reinforcing growth, it is essential to break the vicious circle of lower prices, higher real rates, lower investment, yet higher output gaps, yet lower prices, etc.
Breaking the cycle is far from impossible. Indeed, Japan's own economic history of the last 20 years suggests the very actions that are needed. Policymakers need only recognize and repeat what went right under BoJ Governors Hayami and Fukui, and replicate it. Should they do so, equity markets would likely rise. Moreover, a sustainable fiscal position would be closer, since growth would be more sustainable.
The Lower Bound: ZIRP and Bond Yields
The starting point of my argument is the lower bound on interest rates and/or bond yields. For policy rates, the lower bound is zero, as shown by the zero interest rate policy (ZIRP) of the Bank of Japan in 2001-06.
It is less common to talk about a lower bound for bond yields. Indeed, the 10-year JGB has fallen below 1% during two periods, 1998 and 2003. However, a more bird's eye view of the nominal yields suggests that these movements were panic aberrations. Indeed, since 1999, the long-term yield has remained largely within a band of 1.2-1.8%. It is reasonable to consider 1.2% to be a lower band limit for JGB yields.
Inflation, however, can keep falling even after interest rates or bond yields have hit their lower bound. The most recent recession has shown more virulent deflation than the previous bout, in 2000-01. Indeed, in 1Q10, the real bond yield (nominal 10-year JGB yield less the change of the CPI ex food and energy) has been the highest since 4Q96.
Japan's own recent history hints at what needs to be done today. Once the BoJ recognized that the rate hike of August 2000 was premature, it reverted to ZIRP, but added an important element, the so-called ‘time axis'. On March 19, 2001, the BoJ announced "New Procedures for Money Market Operations and Monetary Easing", and shifted the target for monetary policy from the overnight call rate to the level of current reserves at the BoJ. In addition, the BoJ stated that "The new procedures for money market operations continue to be in place until the consumer price index (excluding perishables, on a nationwide statistics) registers stably at zero percent or an increase year on year". There was a simultaneous shift to quantitative easing (QE) and use of a time-axis.
This initiative was successful. As the reforms of the banking system kicked in, as other structural reforms were adopted, and as growth in China and other trading partners accelerated, the QE/time axis framework kept monetary policy accommodative until the goal of positive inflation was reached.
However, the exit from the QE/time axis monetary regime, in March-July 2006, was premature in two ways. First, the trigger for exit, a 0% increase of consumer prices ex-fresh food, was set too low. Second, the time standard for ‘sustainability' was too loose, as shown by the subsequent course of events: The 2000-base CPI began to exceed 0%Y change in November 2005, at 0.1%. The rise accelerated to 0.5% in January data (reported at end-February). The BoJ announced its exit from QE on March 9, 2006, reverting to a target of ZIRP. On March 10, it announced its "understanding of price stability" to be a range of 0-2%, with a central value of 1%, and switched to the overall CPI (including fresh food) as the key indicator. The BoJ then hiked the overnight call rate to 0.25% on July 14, 2006. The CPI change (both overall and ex-fresh food) peaked in August 2006. Given that the CPI began to deteriorate almost immediately after the BoJ shifted back to rate-targeting, the exit from QE was clearly premature. This would not have occurred had the BoJ been using CPI excluding both food and energy: By that measure, deflation in 2006 was still very much in negative territory.
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